The Deep End of a Dark Pool

There was some speculation that the financial markets in this country would suddenly stagnate after the most recent downturn. The innovation of products that used an ever-increasing and more complicated methodology to make money would stop, paving the way for dull and boring, over-regulated markets that offered so much oversight as to slow the growth of the country. To hear some Wall Streeters talk, the end of an era was upon us.

Not so fast.
Financial markets and those that look for ever smaller ways to extract a decimal from these tough times have rediscovered a product called dark pools. These are ways to trade electronically using the money from a bank, doing so without publicizing the trade until well after it had been executed and even more sinister, allowing traders to see in advance what orders are being placed.

In other words, while we rely on live quotes, these dark pool traders are able to purchase an equity without needing to publicize what the actual quote was. These types of pools have been around for over a decade but were largely underused. There were simply too many other tools of the trade to be utilized while the Bush administration's crippled S.E.C. looked the other way. As long as the market escalated, there was little or no need to decimalize each trade.

But that has changed and the numbers of large and institutional traders that now tap this type of trading platform has increased at a frightening rate of 17% over the last year (from 58% to 70%). While you may say to yourself, what mutual funds, pension funds and hedge funds do to enhance their return is okay by you, some of which you may have an interconnected interest in, the idea that the equity markets may not be fair to all players is not right.

Individual investors have known of these disparities for some time. Beginning of the day and end of the day volumes and volatility have increased to the point that many people could never predict where the market is going to end the day. (Exchange Traded Funds have been to blame for frenzied trading as well.)

Now this subject of who and how these dark pools are being used seems to be getting a little light shed on it from the new chair of the S.E.C. Mary Shapiro. In a recent keynote address at the 2009 SIFMA Market Structure Conference, James A. Brigagliano Co-Acting Director, Division of Trading and Markets U.S. Securities and Exchange Commission wondered if "there is any compelling reason for dark pools to object to improved post-trade transparency." Acknowledging the need for these trades to be dark prior to execution as part of the success of these pools, he couldn't see why "some form of improved post-trade transparency would be likely to interfere with their business models."

The Downside of Speed.
This darkness is however not complete, coming in different shades. Often called indications of interest, these so-called messages done in advance of the trade itself, offering a look to other traders of a trade about to happen, whether it be executed or canceled may resemble a quote too closely.

Because these trades are able to get done very quickly, these "actionable order messages could create the potential for significant private markets to develop that exclude public investors" according to Brigagliano suggesting that because of this "the public does not have fair access."

Mr. Brigagliano has no real beef with the huge block trades that are conducted between institutional investor, often trading in excess of 50,000 shares. But smaller order systems could make the general investing public less likely to want to trade if they feel as though some select individuals get orders processed at a better price based on a quote the general public was unable to see. If that were to happen, the markets would essentially freeze.

He is correct in assuming that "any practice that significantly detracts from the incentives to display liquidity in the public markets could decrease that liquidity and, in turn, harm price discovery and worsen short-term volatility."

At the heart of this reform is a newly energized SEC. So far, they are looking at regulation with a realization that too much regulation would have long-range effects that we would have to live with for years to come and the lack of regulation they inherited needs revamping. Cleaning up the dark pools is one of the ways they hope to do this. Expect Wall Street to resist.

Any transparency is better than none and Ms. Shapiro is making this a focus of her approach to getting the investor’s trust in the US equity markets back on track. The "gaps" in regulation have allowed too many innovators to slip through with products that might make money for some, but threaten the long-term goals of some investors and challenging the trust of others.